One source of funds that you may not have considered is within your non-IRA investment accounts – especially if you have inherent capital gains and losses (even moreso if you have carried-over capital losses that wouldn’t otherwise be utilized readily).

Offsetting Gains With Losses To Produce Cash

Here’s how it works: You sell your “loss” positions, establishing a capital loss for tax purposes.  Then you can sell your “gain” positions in like amounts, giving yourself a tax-free source of cash, since the loss will offset the gain for taxation purposes.

For example – imagine that you have a $100,000 IRA that you’d like to convert.  Running the numbers, you’ve come to realize that the conversion will cost $25,000 to complete.  In addition to the IRA, you also hold some non-IRA money, in the form of two investments.  One of these investments has an inherent loss of $20,000, and the other has an inherent gain of $30,000.

By selling out of the “loss” position completely and selling just enough of the “gain” position to offset the tax loss you’ve realized, you have effectively created a tax-free source of income in the amount of $20,000.  This still leaves $5,000 if you’re planning to convert the entire amount.

After you’ve finished with your conversion activities (and after 30 days has passed so that you don’t run afoul of the wash sale rules), you can re-invest the leftover money in those same investments, keeping your allocation at least similar to what it was before.

At this stage you have three choices, assuming you don’t have an extra $5,000 laying around:

1. You can choose to only convert a portion of your IRA – the amount that you can generate tax-free money to pay tax upon.  In our example, this would be $80,000.
2. You can use more of the cash that you freed up from the sales of your non-IRA gain and loss holdings.
3. You can convert the entire amount and take distribution of the additional $5,000 to pay the extra tax.  Actually you’d need to pull out $5,500 in order to pay the penalty on that amount that you’re distributing.

Of these three, I’d recommend option 2, which is the outcome where you complete the conversion of the entire amount without having to pay additional tax or penalty on the money that you’re using to pay the tax on the conversion.  Yeah, that last sentence belongs in a museum.  Happy converting!

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The recent stock market activity has given us plenty of opportunities to experience extremes of emotion… but then again, you can pretty much choose any time period and make a similar statement.  There are quite a few studies that have recently brought to the forefront several things that we need to understand about ourselves and how emotion could impact our decision-making process.

Loss Aversion – as investors in general, we feel the impact of a loss approximately twice as much as we experience the good feelings from a gain.  It has further been estimated that as we approach retirement, this ratio increases to a factor of five times more pain for a loss as opposed to the joy we experience for a gain.

This seems to be true no matter whether the loss is realized or simply on paper.  The problem is that, in stock market investing, short term losses and gains are simply normal market activity, and we need to temper our emotions to keep things in perspective.

We Want Control… or Do We? – it would seem to follow the train of thought that, if we are feeling pain in our investing activities that we’d appreciate some guarantees and protection of some sort in our choices of products.  However, guarantees come with a cost – that of giving up control.  And as investors we prefer control (or the perception of control) over guarantees, studies have shown.

On the other hand, other studies tell us that a guaranteed income from an investment is preferred over an assured return on investment over time.  These studies show that, given a choice between an annuity with a monthly income and an investment portfolio structured to provide the same sort of returns over time, if we’re near retirement we choose the annuity seven times out of ten.

This means that we value the concept of income, that of receiving a check every month over the excess costs and lack of control that an annuity represents.  At the same time, we prefer to feel like we’re in control of our investing activities.

Lack of Understanding of the Numbers – when presented with the outcome of financial calculators, many of us consider whatever calculations were done in the background to be tantamount to magic.  For example, the very concept of inflation and its impact on our future finances is a mystery to us – we work best when calculations are discounted to present values.

Even though it’s been decided that it was politically incorrect, one popular baby-boomer who is now age 51 once admitted that math is tough (Barbie, of the doll fame, who actually admitted that “Math class is tough”).  There’s no shame in admitting that fact – for a lot of us, math can be very tough.  And as we get older (some say by age 53) our understanding of mathematical numeracy begins to decline dramatically, making math even tougher.

This can lead to distrust of the very calculations that could help you make good decisions in your financial life.

So What Does All Of This Mean?

Mostly this just means that we’re carrying with us a lot of preconceived notions and emotional preferences that we must take into account as we make financial decisions.  “Know Thyself” means that we should understand how these various notions can paint our perceptions of situations, and if we understand these things, we can recognize when our own limitations are working against us and take actions to consider things in a new, less biased, light.

For example, it’s natural to feel the pain of losses.  But as explained in the article The Lost Decade and What It Means, the activity of investing, especially in the stock markets, is a long-term activity and short-term losses, even over a few years, are temporary in the scheme of things.  Keep this in mind before making any rash investment decisions – you’re likely to regret emotion-driven decisions.

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10 Facts About Capital Gains and Losses

1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset.
2. When you sell a capital asset, the difference between the amount you sell it for and your basis – which is usually what you paid for it – is a capital gain or a capital loss.
3. You must report all capital gains on your income tax return.
4. You may deduct capital losses only on investment property, not on property held for personal use.
5. Capital gains and losses are classified as long-term or short term, depending on how long you hold the property before you sell it.  If you hold it more than one year, your capital gain or loss is long-term.  If you hold it one year or less, your capital gain or loss is short-term.
6. If you have long-term gains in excess of your long-term losses, you have a net capital gain to the extent your net long-term capital gain is more than your net short-term capital loss, if any.
7. The tax rates that apply to net long-term capital gains are generally lower than the tax rates that apply to other income.  For 2010, the maximum long-term capital gains rate for most people is 15%.  For lower-income individuals, the rate may be 0% on some or all of the net capital gain.  Special types of net capital gain can be taxed at 25% or 28%.
8. If your capital losses exceed your capital gains, the excess loss can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.
9. If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that year.
10. Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.

Calculations

To determine tax treatment, your short-term capital gains (STCG) and short-term capital losses (STCL) are “netted”, and the same is done with your long-term capital gains (LTCG) and long-term capital losses (LTCL), as in the following equations:

STCG – STCL = Net STCG(or L)

LTCG – LTCL = Net LTCG(or L)

If the amount of loss (in either equation) is greater than then amount of gain, you have a net capital loss (either short or long).  Likewise if the amount of gain is greater than the amount of loss, you have a net capital gain.  These amounts are then netted against each other, as follows:

Net Capital Gains = Net STCG(or L) + Net LTCG(or L)

Tax Treatment Situations

If you have only short-term gains and losses, any net gain will be taxed at your ordinary income tax rate – that is, it is added to your other income from wages and the like, taxed just the same as income.  A net loss can be deducted from your income to the extent of the $3,000 annual limit discussed previously.  Any remaining net loss can be carried over to future years and deducted against net capital gains first, and then at the $3,000-per-year rate against your ordinary income until the net loss is exhausted.

Likewise, if you have both short-term and long-term gains and losses and the net short-term gains are greater than any net long-term losses, the remaining difference is taxed and treated as ordinary income.

If you have only long-term gains and losses, any net gain will be taxed at the applicable long-term capital gains rates (typically 0% or 15% for 2010).  Any net loss is treated the same as the net short-term capital loss described above.

If you have net long-term gains and net short-term losses that are less than or equal to the net long-term gains, in the “netting” discussed above, your net long-term gains will be reduced to the extent of your net short-term losses.

If the nettings result in net capital gains for both long-term and short-term, your net short-term gains will again be taxed at your ordinary income tax rate, but the net long-term gains will be taxed at the applicable long-term capital gains rate (typically either 0% or 15% for 2010).

And lastly, if the nettings result in net capital losses for both holding periods, this net loss is (as you might expect) allowed to be deducted from ordinary income at the $3,000-per-year rate.  Any amount of loss that remains is carried over to future years (as described previously).

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In general, what I see in response to this question is high – much too high to be realistic.  If you look at the stock market over long periods of time, you’ll see that the annualized return over the past 100 years was roughly 9.4% (including reinvested dividends), for example.  What’s important is to understand how market returns are composed, in order to put it all into context.

How Market Returns Are Composed

Stock market returns are made up of several components:  the amount of return that stocks earn above the “risk-free” rate of return of Treasury Bills (known as the equity premium), plus the risk free rate of return, plus the rate of inflation.  This is usually expressed as an equation:

Inflation + Risk-Free Rate + Equity Premium = Equity Return

If you looked at present figures, you’d see that Inflation is presently running around 2.2% (CPI-U, since April 2009).  The Risk-Free Rate is presently something like 0.7%, and the historic Equity Premium is around 4.8%.  Adding all this together we come up with

2.2% + 0.7% + 4.8% = 7.7%

The key to all of this is not exactly what figure we come up with, but to give us an idea of what composes the return figures.  If you happen to receive a return of 7.7%, that would be quite a coincidence indeed – this calculation gives us an expectation to aim for, and that is all.

But understanding that inflation is one of the primary components of this equation, along with the rate of return on Treasury Bills, helps us to understand why low inflation and low interest rates (like we’re experiencing these days) often equates to lower than the historic average in terms of overall stock market returns.

Going back to the last 100 years’ figures, we see that the rate of inflation averaged 3.13% during that period.  If we consider that the risk-free return for the period was roughly 0.9%, we calculate that the Equity Premium for the period was approximately 5.36% as such:

9.41% – 3.13% – 0.9% = 5.36%

This reflects only a 0.56% differential in the Equity Premium between today’s figures and the historic averages.  The past 50 years experienced a higher rate of inflation (4.08%) with approximately the same average return (9.45%) and risk-free rate (0.9%), which suggests that the Equity Premium has been lower during that period, somewhere around 4.47%, which is still significant.

But It’s The Portfolio We’re Talking About…

Keep in mind, we’re not only talking about stock market returns – we’re talking about overall portfolio return expectations.  If we assume that the averaged-out rate of return that we can expect (in terms of premium over inflation and risk-free returns) is reduced by 2-3%, then in today’s marketplace with the 7.7% expected equity return, our blended return should range between 3% to 7.7% across the spectrum.

That may seem anemic, especially in the context of the crazy 15%, 18% or 20% returns we’ve seen in years past – but as we saw, those returns were based on some crazy bubble-based speculations.  The expectation of returns in those periods had no basis in reality… so welcome back to reality.  The point is that you need to be realistic about the returns we expect.  There’s no benefit to you by expecting a 20% return when it’s highly unlikely to be delivered.  Don’t get me wrong, I believe in being optimistic – but not when it can be detrimental to your financial life.

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But what does this mean?  There are plenty of folks out there (in the mass media) who will tell you that stock market investing is no longer a wise move… why, after all, if you’d had your money in a savings account you’d have done better!  So does this mean it’s time to chuck all of your stock investments and switch everything to bonds?  Of course not.

Remember, it’s long term

No matter who you are as an investor, if you expect to achieve any return above inflation, you have to include equities (stocks) in your portfolio to some extent.  And when developing portfolio allocations, pretty much anyone under age 70 should be considering a time horizon of 30 years or more – and those over age 70 should be thinking similarly, since your chance of living to age 95+ is continuing to increase every year.

What I mean by this long-term view is that you need to stop thinking about stocks in a day-to-day, quarter-to-quarter, year-to-year or even decade-to-decade context, but rather in the context of thirty, forty, fifty and more years.   A college graduate, just starting a new job this year and investing in a sparkly-new 401(k) may likely be continuing to take distributions from that 401(k) in the year 2080, for example.  Even if you’re retiring this year at age 62 – you may still have 30 or more years of investment activity ahead of you.

Think about all that has happened in our history over the past 30, 40, 50, 60, and 70 years – 70 years ago we were still over 18 months away from Pearl Harbor and the US entry into World War II.  We’re talking about a significant amount of history that has occurred – and a likewise significant amount of returns that stocks have provided over that time.

So let’s look at the numbers for the S&P 500 more closely:

* These annualized numbers are inflation-adjusted and include re-invested dividends

Notice how the numbers fluctuate pretty wildly among the 10-year periods, but begin to calm down as you look at the longer-term time horizons.  While there is nearly a 20% differential between the best and worst 10-year periods, when you look at the 30-year periods the differential is less than 4.75%, and over the 70-year periods the differential is even less:  only 2% separates the best period from the worst.

So, while you may have an off decade or two in your overall investing experience, in the long term you’re likely to approach the average return, as long as you keep your head and remain vigilant with your investment allocation in good times and bad.

Why A Decade?

The other thing about this “lost decade” business that bothers me is that it’s an arbitrarily-chosen timeframe – why do we only want to measure in terms of an exact decade?  What if we started these periods in March of the years ending with 3?

* These annualized numbers are inflation-adjusted and include re-invested dividends

As you can see, within reason, these periods averaged out very similar when compared to the exact decades, but the differential between the best and worst decades was much different (this would be referred to as the “deviation” of the returns).  And as we noted in the first table, as the time horizon increases, the deviation reduces to very near the average for that timeframe.

So, don’t get hung up on an arbitrary measure such as this to begin with.  Recent history has a very poor track record for predicting the future (in short term views, especially) – remember how heady the market was after the 1980′s and 1990′s dramatic returns?  No fool would have suggested that you shouldn’t be in stocks at the turn of the millennium – but look at what has happened since then.  Same thing goes for the end of the 1970′s – stocks looked like a terrible place to be, but then along came the bull markets of the 1980′s and 1990′s.

Taking another view – when there’s a downswing in the markets, when you’re in the position of continual investing, you’re actually getting more shares for your money than in the upswing periods.  In the long run this gives you a much better footing than a single lump sum invested at (perhaps) the wrong time.

The Point

The point of all this is that if you have a long-term horizon (and we all do, to some degree) and you hope to earn something more than the level of inflation, stocks are your best bet.  And holding your properly-diversified portfolio of stocks through thick and thin is the best method for investing in the market – lost decade or not.  Because in the long run, stocks are most likely to return their historical long run average – which is much better than any other alternative investment out there.

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The trick to all of this is to know how much to have in each kind of account… of course there are no hard and fast rules to determine what’s the best percentage to have in each kind of plan, but below is a discussion of some of the factors that you should consider as you balance out your tax treatment.

Early in life…

Early in your investing career it probably makes the most sense to load as much of your savings into your 401(k) or other tax-deferred savings vehicle as possible, in order to maximize the benefit from tax savings up front.  The biggest reason for this (beyond the tax savings) is so that you take advantage of your employer’s matching benefit, along with deferring taxes on your income as it increases over time.

Later in your career when your income is higher, maximizing contributions to tax-deferred accounts will have a greater benefit to you from a tax savings standpoint – and this is assuming that you expect for the taxes you’ll pay later (during retirement) will be lower due to your diversification of tax treatment.

Also early in your investing career, as your income supports it you should begin making contributions to your Roth IRA as soon as possible.  This is partly due to the restrictions on income around investing in Roth IRAs – but mostly because you are paying tax at lower rates (in your lower-earning days) than you might later on in your career when your income increases.

And then on top of it all, when your income has grown to a point that you can maximize the other options (401(k) and Roth), you should begin investing in an account that is treated by capital gains tax (primarily).  This will give you the third leg of the tax-diversification stool.  Since capital gains are (presently) taxed at a much lower rate than ordinary income – which is what your IRA or 401(k) distributions are taxed at – it makes a great deal of sense to have some of your money invested in these accounts as well.

Later in life…

Later on in your life, as you reach that point where you will have to begin taking Required Minimum Distributions (RMDs) from your IRA and 401(k) accounts, it might make sense to take significant portions of those accounts and either convert them to Roth accounts or capital gains taxed accounts.  The preference would be to place the funds distributed into a Roth IRA, especially if you are in a position where you will not need access to the funds for some time and therefore can benefit from the tax-free growth of the account.  But you may also want to balance those conversions to Roth with some non-tax-deferred investments as well – because you never know what may happen with the tax code.

It’s (very!) possible, given the government’s need to increase tax revenues to pay for things like the health care initiative, that there could be changes in the works for how tax-deferred plans are taxed.  Just a few options that have been put forth in recent memory include:

• extra taxes on IRA assets (this was in place back in the mid-80’s)
• changes to the minimum distribution rules to require faster distribution or to eliminate “stretch” capabilities
• adding investment restrictions, such as requiring a portion of IRAs to be invested in “socially responsible” investments
• nationalization of retirement accounts – e.g., governmental takeover of all IRA and 401(k) plans in exchange for a superannuization plan like some socialized countries use

Yet another option, especially if you have very few assets outside your IRAs and 401(k) plans, you can reduce your taxable estate (when we have an estate tax again, that is) by taking extra distributions from your IRA or 401(k) and making gifts to your children and grandchildren.  You could place the assets in a trust that represents a completed gift, or give the money directly to your future heirs – this way you are able to see your children and grandchildren enjoying the fruits of your labors while you’re still living.

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(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb.  Therefore, we’re talking about Rules of Thumb.)

In this installment of the Principles of Pollex, we address a compelling Investment Allocation Rule of Thumb:  Invest X% of your money in bonds, and the remainder in stocks – where “X” is equal to your age.  According to this rule, if you’re 35 years old, you’ll have 35% invested in bonds and 65% invested in stocks.

What’s Good About It

Absent any other allocation strategy, at least this strategy provides you with a method for scaling back your exposure to stocks over time.  It’s important to understand that your risk exposure should be continually reducing as you reach closer and closer to your goal.

On top of the structure, using such an allocation strategy will require you to be more conservative earlier on in your investing life, and less conservative later in your life, than most folks would normally be.  Left to our own devices, we’d be a little more likely to be overly aggressive in the early years (100% stocks, for example) when we ought to have an exposure to bonds to help balance out the portfolio to help us make it through market downturns without losing faith.

In addition, as we start into retirement years, too often we think that we should become totally conservative (100% bonds) when in actuality we have a long time (30+ years left in our projected life) to make the portfolio continue to work for us.  With that long-term horizon we need to have an exposure to stocks in order to keep up with inflation and have continued growth in the portfolio.

What’s Not So Good

As with all Rules of Thumb, the problem with this one is that it’s too general to be appropriate for everyone – really for anyone.  For most people with long-term investing horizons, such as 25 years or more, this allocation scheme is very conservative, and may result in needlessly squelching possible returns early in your investing career.

On the other hand, if you had chosen this sort of allocation scheme, you’d be (likely) much better insulated against significant stock market downturns like the one in late 2008 and early 2009, than if you’d gone with a 100% stock exposure.

Additionally, while this rule of thumb does account for your timeline to a degree, assuming that at retirement (let’s say age 65) your risk tolerance and requirement for returns is in the range where a 65% bond/35% stock portfolio will meet your needs.  The problem is that this is probably too conservative to meet most folks’ needs over the 30 or more years that you need the portfolio to continue meeting inflation and growing.

Lastly, this allocation plan only takes into account the two very broad allocation options of stocks and bonds.  A well-diversified portfolio may also include sub-categories of global bonds and stocks, commodities, real estate, and other components that are not so easily “thumbed”.

A Better Way

If you need a rule of thumb, maybe you could take this same one and put in an additional factor to make it not quite so conservative – like adding 25% to the stock factor, and possibly limiting both factors to no less than 10%.  So, for a person age 35, you would have a stock component of 90% (100% minus your age, 35, plus 25% equals 90%) and a bond component of 10%.  Each subsequent year you’d increase the bond portion by 1% and decrease the stock portion by 1%.  At any age less than 35, you’d still be at a 90/10 stock-to-bond ratio.  Upon retirement you might reduce the additional 25% factor somewhat – maybe to add 10%, for example – so that at age 65 your ratio would be 45% stock, 55% bond.

Yet a better way would be to work with a professional financial advisor to lay out a proper allocation plan that is tuned to your own timeline, risk tolerance, and preferences. But if you’re fixed on doing it yourself, this adapted principle of pollex may be useful to you.  You will probably want to put a little more effort into your plan than this – and likely you will over time.

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Mistakes With NUA

Moving too quickly – if you roll over your funds from the Qualified Retirement Plan (QRP) without first checking to see if there can be a benefit from the NUA treatment of company stock in the QRP, you’ve lost the chance to do so.  Always check for NUA possibility within the QRP before making any rollover moves.

Not moving quickly (completely) enough – if you have determined that NUA treatment can benefit your situation, you must move ALL of the funds from the QRP within the same taxable year.  If you moved your NUA stock out first and planned to rollover the rest of the account into an IRA or other employer plan, you must follow through within the tax year – delaying even one day beyond the tax year end will break the NUA option and cause the distributed stock to be fully taxable.

Taking RMDs in an earlier year – if you retired in an earlier year, and began taking Required Minimum Distributions (RMDs), once that tax year ends and you have not taken your Lump Sum Distribution to enact the NUA option, you no longer have the NUA option available to you.  This is due to the fact that the NUA option is available ONLY after a triggering event, and the entire balance must be withdrawn in a single tax year.  If another triggering event were to occur – disability or death – then the NUA treatment could still be available.

Selling out of NUA-potential stock in the QRP – if you have significant holdings of your company’s stock in your QRP, chances are at some point you’ll get nervous about holding too much stock in a single company.  Obviously, you don’t want to overexpose yourself to a volatile stock – but it may not make sense to sell all the stock, either.  If the stock has appreciated over a significant period of time, you might want to maintain a position simply to take advantage of the NUA treatment.

On the other hand, if you’re concerned that the stock is going to drop like a rock, (remember Enron? Worldcomm? CitiGroup? Countrywide?) you should ignore the concept of NUA altogether – you shouldn’t let tax laws wag the financial responsibility dog.  Besides, if the stock drops there wouldn’t be any NUA treatment anyhow.

Not understanding NUA – if you don’t understand it completely, your chances of getting it right are small.  This is a very strict set of rules (aren’t they all though?) and simple moves in the wrong direction can break the option altogether, potentially causing a major tax hit.  It’s also important for your heirs to understand NUA – or make sure that they will work with your NUA-savvy advisor before they make any moves.

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Now is the time to look back and review our actions during this difficult period – review is useful for us to understand what helped us weather the storm and wind up with positive outcomes.  According to some of the things I’ve been seeing and reading, it appears that many folks came through the financial crisis pretty much unscathed.

What We Did Right

We Didn’t Panic – As in most “crisis” situations, it’s a good thing to maintain calm.  In this specific crisis, we held true and didn’t make sudden moves to react to the situation.  Since we had a  well-thought-out plan in place, we stuck to it and, even though we saw our accounts decrease in value – we were able to take advantage of the increases that the stock market provided later.

Good diversification across all asset classes also kept us from feeling the pain that concentrated positions could have caused.  We found that investing globally helps to balance out any one country’s problems so that we are able to retain and grow our funds through thick and thin.

We Didn’t Listen to the Pundits – You know that in this information-deluged age we live in, you can get opinions on the financial world at any moment from dozens of talking heads on the TV and internet.  At any one time you can find someone telling you to buy the market and another telling you you’re crazy if you don’t sell the market.  You did the right thing by recognizing that these folks are entertainers first and foremost.  If it’s fantastic and draws attention, they’ll say it – whether it has merit or not.

We Slowed Borrowing and Living On Credit – Recent reports tell us that consumer non-mortgage credit has dropped off during the past year and a half, when compared to mortgage debt.  Both figures are still high (more than 10% of income is servicing mortgages, and nearly 6% is spent servicing other credit), but these figures have come down from the all-time highs we saw a few years ago.  If what I believe about you, my readers, is true, you are on the much more conservative side of those figures, and you have strived to improve your situation through this crisis when possible.

We Continued Saving – From what I read, it appears that most everyone who is in the position to add to savings and retirement accounts, continued to do so during the financial crisis.  According to Vanguard, a high percentage of retirement plan participants (especially younger participants) have higher balances in their accounts now than they had two years previous – at some of the market highs.

As we all know, one of the most important factors of success in a saving and investing plan is to continue with systematic savings in good times and bad.  Continuing to save and invest even when all the noise going on around you said that you should stay away from investing has worked and worked well forever.  By doing so, you benefited from the dollar-cost-averaging aspect of systematic investing, buying low during the market downturn, and then riding the massive increases we have seen in the market over the past year.

Bottom Line

All in all, we did a good job of recognizing that the markets can’t be controlled, but that we can exercise a degree of control by having a diversified investment plan and by determining that we’ll continue to put aside funds for that eventual sunny day we’re all hoping to see. As I mentioned in a previous article, it’s always good to save 10% to 20% (or more), live within our means, and invest, diversified, for the long term.  These few tenets have served us well – in good times, and as we’ve now seen, in bad.  Keep up the good work!

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Post from: Getting Your Financial Ducks In A Row

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

No Personal Use

This is a thorny question, because there are lots of restrictions around this sort of purchase with an IRA account.  First of all, you need to understand that you cannot use the real estate personally, if it is owned by your IRA.  Specifically, you, your spouse, heirs, and any other linear relatives can not use such a piece of real estate while your IRA owns it.  That factor in itself should answer the question for a lot of folks.

So, for example you could not – purchase a home in a sunny clime and use it for your own purposes two months out of the year (allowing your family members to stay there, in addition to your own two weeks during the winter, for example) and then rent it out the rest of the year.  The IRS disallows such use, and will consider your real estate investment to have been distributed, and therefore fully taxable as ordinary income.

On the other hand, if you owned such a home and rented it out for a profit, this could still be owned by your IRA.

Additional Issues

If you’re still reading, you must be determined to try this anyhow, so here are some additional issues that you need to deal with… If you use a mortgage (actually a special type of mortgage called a non-recourse loan) to purchase the property, regardless of how it is used, the income from the property will be considered Unrelated Business Taxable Income (UBTI) and therefore taxable in the current year.  This particular wrinkle has caused many IRA real estate investors to lose the qualification on their money and owe tax on the entire account.

In addition to the UBTI issue, there are more restrictions:  you cannot provide services to your IRA, such as sweat equity in fixing up the old fixer-upper or managing the property yourself (you would have to use a third-party manager); you also cannot sell a piece of property that you own to your IRA (or purchase it from a relative); any income from the property must be deposited in the IRA account, and all expenses associated with the property must be paid by the IRA account.  If your IRA account doesn’t have enough cash on hand to pay insurance and property taxes, for example, you might have to either sell the property or distribute it to yourself in order to make sure those payments are made – otherwise if you paid the expense yourself the IRA could become immediately taxable to you.

Distribution

Lastly, as you decide that you’re going to now occupy the home, you have to distribute the property from the IRA – making the entire then-current value of the home subject to ordinary income tax.  So if you purchased a home in a depressed area (think Florida coast, for example) at $100,000, and then five years later when you want to move into the home when it is valued at $200,000 – you have to pay ordinary income tax on the entire $200,000 in one year.  If you had very little other income for the year, the ordinary income tax (federal only) would amount to $56,000 (using 2010 tax rates).

Bottom Line

If there is a piece of property that you could not otherwise purchase, using IRA funds might not be a bad way to go.  I would suggest a couple of things though: 1) you should purchase the property outright if you can, to avoid the whole UBTI issue; 2) you should plan your income in the year of distribution, so that you limit the ordinary income tax hit; 3) hire an experienced “Self-Directed IRA” trustee to help you through the process.  Because this process can be so very complicated and fraught with error, it will pay off for you to get someone on your side that has handled these transactions successfully in the past.

However, in my opinion, using the IRA to own property that you eventually will occupy is an enormous headache that you could probably do without.  If you really want to own real estate in your IRA as an investment, look at rental property or commercial property – perhaps in a REIT.  Owning real estate outside an IRA is a big enough headache, and when you add all of the additional restrictions to the process, I can’t imagine that it would be worthwhile.

Here’s a better idea:  wait until you’re ready to retire, then find that property that you want, and use distributions from your IRA to fund a mortgage on the property (or if you really want to, distribute the funds and buy it outright without a loan).  You’ll have far less headaches, and the outcome will be very similar.  Good luck!

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Post from: Getting Your Financial Ducks In A Row

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).